Central Banks Creating A Looming Bubble in Long-Term Debt

In the aftermath of the financial crisis of 2007–2009, analysts and prognosticators have constantly argued over [what will likely be] the next big bubble: will it be in auto loans, in equities, government bonds, or even in housing again? However, the biggest risk facing financial markets may be the financial asset duration bubble. [Let me explain why that may well be the case.]

The comments above and below are excerpts from an articleby Mark Tiberius (mises.org) which may have been enhanced – edited ([ ]) and abridged (…) – bymunKNEE.com(Your Key to Making Money!) to provide you with a faster & easier read. Register to receive our bi-weekly Market Intelligence Report newsletter (see sample here , sign up in top right hand corner.)

Since 2009, large institutions including central banks, sovereign wealth funds, pension funds, and insurance companies have acquired longer-dated assets to achieve needed returns on yield. Years of monetary policy stimulus from the world’s major central banks has suppressed interest rates worldwide to all-time lows. While this may be viewed as a stimulating policy for borrowers, it creates serious issues for financial institutions with required levels of investment returns and with future liabilities.

What is Duration Risk?

Pension funds and insurance companies invest in assets that pay a yield, which can include coupon payments on fixed income securities (like US Treasuries or corporate bonds) as well as price appreciation over time, in order to “fund” their future liabilities. A pension fund, for instance, must ensure that they achieve a certain level of returns (often as high as 7 percent) in order to fulfill the promises made to their employees when they retire. When interest rates fall, the present value of these unfunded obligations starts to rise — because they are “discounting” this future obligation with the market rate of interest. The lower the interest rate used for the discounting, the higher the value of the liability (or asset).

Insurance companies must do the same, in order to be prepared to pay out varying types of claims depending on the line of insurance they operate in (property & casualty typically has shorter-term payouts than life). As a result of this artificially low interest rate environment, which has been running for almost 8 years now, these incredibly important institutions have very high duration risk on their balance sheets. “Duration” is simply a measure of an asset’s price sensitivity to a change in interest rates, with longer-maturity securities having much higher duration than shorter-term ones.

While longer-dated bonds may provide higher coupons and overall yield, the other end of that double-edged sword is that they represent a massive danger should rates start marching higher.

According to Bloomberg’s index, the effective average duration of the global bond market currently is 6.98 years. This is considered uncomfortably high by historical standards. Goldman Sachs, for instance, forecasts that a simple 1 percent increase in interest rates could inflict $1.1 trillion in losses to the Bloomberg Barclays U.S. Aggregate Index, representing a larger loss for bondholders than any other time in history! This figure doesn’t include other forms of securities such as bank loans on company balance sheets or interest rate derivative contracts. The institutions mentioned above hold many of the assets that comprise this index — and thanks to years of monetary policy stimulus we have a major duration bubble on our hands.

What if Central Banks Postpone Hikes?

Should central banks choose to punt off rate hikes, as they have done countless times during this tepid global recovery, then there is still a massive bubble concern. In order to achieve “asset-liability matching,” where the duration of their assets is lined up with that of their obligations (the payments to pensioners or claims to insurance policyholders); these institutions must buy more and more long-term government and corporate bonds to hedge their growing liability risks. This drives rates down even further, which then becomes a negative feedback loop as the obligations then rise further in present value, which in turn causes more long-term asset purchases!

Although QE has ended here in the United States, it continues in Europe and Japan — and that has spillover effects in the US. More than $10 trillion of debt globally, mostly in Europe and Japan, have negative yields. This has spurred investors to buy US dollar-denominated bonds — further exacerbating the low-rate problem facing many large investors. The deluge of foreign money into the US corporate bond market, roughly $146 billion in the 12 months through July 2016, has helped push insurance companies and pension funds further out on the yield curve. This has continued to heighten duration risk, and made our financial system even more vulnerable to any interest rate increases.

Which Way to Go?

As more institutions get involved in this chase for yield, while simultaneously ensuring they match their liabilities, it becomes far harder for central banks to “manage” asset bubbles and achieve their monetary policy objectives. It is a precarious position, where a sharp rise in rates will lead to massive investor losses and a continued fall in rates could lead to dangerous new bubbles as well as a potential liquidity issue with a government bond shortage (specifically in Europe). However, it is far preferable to take the pain now through a much-needed hiking cycle than by letting the distortions continue further.

Kicking the can down the road will only lead to more pain later, but central banks have repeatedly made clear that some short-term pain for long-term gain is not something they will tolerate.

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